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Abstract

With global development aid budgets on the decline, impact investing offers a cost-effective alternative to financing international development without deficit spending. The U.S. Government recently became an active participant in this space, investing in new funds and taking steps to clarify the tax code, but can and should do more to expand the global impact economy.

Impact Investing as a Tool for Development

As the global economic downturn persists, cuts in public spending across the developed world are having serious implications for international development. In 2011, aid from major donors dropped by nearly three percent, falling for the first time since 1997.1 In the United States, the sequestration that commenced in March includes forced cuts that would reduce foreign assistance by $1.8 billion, with funding for global health and humanitarian assistance particularly hard hit.2 As a result, the United States cannot afford to tackle many of today’s urgent social and environmental problems. Philanthropic organizations, which can usually narrow the funding gap, are struggling to rebound from the biggest decline in giving in over 40 years.3 Impact investing offers an alternative, cost-effective approach to financing international development without deficit spending.

Impact investing is an emerging subset of the financial community that aims to allocate capital to ventures, often called social enterprises, which address critical social and environmental issues while also generating positive financial returns. This combination is referred to as the “blended value” or “double or triple bottom line” of impact investing. Impact investing is a fusion of traditional profit-maximizing investing and philanthropy. It is distinct from socially responsible investing, or SRI, which primarily employs “negative screens” to block investments in unsavory sectors such as tobacco and firearms rather than intentionally furthering a social mission. The impact investment market is an estimated $50 billion global industry, with projections that it could expand to $500 billion or even $1 trillion in total assets under management over the next decade.4,5

The U.S. Government as an Impact Investor

Traditional development players, including the U.S. Government, are actively exploring ways in which impact investing can help maximize the effectiveness of limited public dollars. One of the most important public actors in international impact investing is the Overseas Private Investment Corporation

(OPIC), the U.S. Government’s development finance institution. This small, independent agency is charged with mobilizing private capital to address development needs. It accomplishes this mission by offering loans, guarantees, and political risk insurance to American companies and private equity funds investing in development projects in emerging markets. In March 2011, OPIC announced its first-ever call for proposals for impact investment funds. This competitive process solicited proposals from private fund managers and other financial intermediaries to establish new funds with social or environmental missions in the countries where OPIC operates. OPIC then selected six funds to which it committed $285 million in financing. That figure represents the largest

U.S. Government commitment to the sector to date. The chosen funds address a diverse set of challenges such as improving health care in Africa, cultivating small businesses in post-conflict countries, preserving forests through projects that generate carbon credits, and bringing mobile banking to those without access to traditional banking services. Through an equity-like debt product, OPIC financing provides leverage to private investors, mitigating the risks they face while increasing their return on equity. By layering private and public dollars, these six funds could provide up to $875 million for investments that save lives, improve livelihoods, and preserve the environment.

As this initiative demonstrates, impact investing has tremendous potential to transform the way we finance development. By combining developmental returns with financial ones, impact investing provides longterm social and environmental benefits at a price the U.S. taxpayer can afford. In fact, by employing a loan-based modes instead of grant-based one, OPIC actually makes a modest profit that is returned to the American taxpayer instead of contributing to the federal deficit. As OPIC President and CEO Elizabeth Littlefield explains, “Every one of those dollars that we catalyze from the private sector is one more dollar that does not need to be spent by the public sector or philanthropists and that can be shifted toward other priorities or back to the taxpayer.”6

Challenges and Skepticism

Despite the growing hype surrounding the field, impact investing should be viewed with a modest dose of skepticism. Impact investors run the gamut from private equity funds to government agencies to nonprofit organizations, and they all maintain widely divergent expectations about the appropriate development and financial returns for their investments. It is important to define and align these expectations, establish common metrics for measuring development returns, and ensure that the focus of impact investing remains on impact. The financial return should be seen as a means to an end, rather than an end in itself. In addition, regulatory treatment of impact investors remains muddled, with questions ranging from the appropriate corporate form of investmentto use to their access to finance.

A number of these shortcomings are being sufficiently addressed by private actors. For example, the Impact Reporting and Investment Standards (IRIS) initiative of the Global Impact Investing Network (GIIN) is collecting data from voluntary investors that it will use to establish standard metrics for impact investments. Building upon this initiative, the Global Impact Investing Rating System (GIIRS) will apply the IRIS metrics to develop an independent ratings and analytics platform similar to the Morningstar investment rankings, used by traditional investors. This platform will provide transparent ratings of impact investment opportunities and allow investors to compare projects across sectors and markets. These initiatives will help scale the impact investing marketplace by removing some of the barriers to entry and facilitate smarter and more effective allocation of capital.

Other challenges facing impact investing require federal assistance. Although most of the focus on impact investing is international, the majority of participants are actually based in the United States.7 As such, U.S. tax code and regulations can either advance or obstruct the development of the global impact economy. Corporate formation is a prime example. Traditionally, companies are established as either for-profit or notfor-profit. For social enterprises meeting a double bottom line, neither shoe fits. For-profits are required to maximize financial returns regardless of social returns − a fiduciary duty that is legally binding for publicly traded companies. As state law has historically governed corporate formation, several states (most notably Maryland and Vermont) have responded to the market demand for a hybrid corporate structure that better meets the needs of social enterprises. These new structures provide legal protection for decision-making that is based on the mission of the organization rather than the pursuit of profit. For example, the “Benefit Corporation” requires a social mission statement and social mission management that serves as an added corporate layer, and directors of Benefit Corporations are legally permitted to consider their mission over financial returns without risk of litigation.

Another option, the Low Income, Limited Liability Corporation (L3C), is a social-impact version of the standard LLC. However, widespread state action is unlikely to reach a tipping point without federal guidance.

Another challenge facing the impact economy is embedded in the U.S. tax code. Tax burdens are a product of corporate structure; non-profits enjoy tax exemptions and offer tax advantages to donors, whereas for-profit entities do not qualify for these measures. As a result, from an investor’s perspective, a donation to a traditional non-profit (which provides a guaranteed tax benefit) is more attractive than an impact investment in a for-profit entity that offers only minimal financial returns, at best. This treatment does not accurately measure or reward the enormous positive externalities of impact investments.

Furthermore, non-profits face severe restrictions on their ability to access private capital and distribute income. They have limited access to debt and no access to equity. They can participate in impact investing through program related investments (investments that accept below-market returns and must serve a tax-exempt purpose, without being significantly aimed at generating revenues). However, the Internal Revenue Service (IRS) ruling process to verify that an investment qualifies can be onerous and costly. As an added disincentive, if an investment is made, that the IRS later determines does not qualify, the foundation faces steep tax penalties. To address these issues, in May 2012 the U.S. Treasury Department and the IRS released a proposed rule that includes new guidelines and updated examples of acceptable program-related investments.8 This update, the first since these investments were implemented over 40 years ago, will facilitate program-related investments by nonprofit organizations and foundations while also lowering their transaction costs. This step in the right direction illustrates how seemingly small administrative adjustments can have big consequences for the impact economy.

The Future of Impact Investing

The U.S. Government should continue to lead by building the foundation for a global impact economy. For example, the IRS should undertake an expedited review of hybrid corporate models and issue a revenue ruling that both recognizes new corporate structures for impact investors and social enterprises while simultaneously reducing their tax burdens. At the international level, government actors like OPIC, the U.S. Department of State, and the U.S. Agency for International Development (USAID) should continue to expand responsible programs that stimulate impact investments. One particularly promising endeavor is USAID’s Development Innovation Ventures (DIV), which provides grants to breakthrough solutions to development issues, in amounts that increase as projects are analytically tested and proven. A careful monitoring and evaluation of such government programs can provide the data and track record necessary to expand the sector in a sustainable way.

However, the reality is that not all development programs can be made commercially viable. Impact investing is an applicable tool for many sectors, but can never completely supplant traditional development aid. That being said, we have entered an era in which government budgets must be trimmed and dollars, once spent abroad, are being diverted to domestic uses. At the same time, the development challenges we face are more daunting and global than ever. While impact investing is no silver bullet, a thriving impact economy could offset reductions in public spending by catalyzing private capital to meet development needs. When the financial crisis struck in 2007, modern capitalism and profit-seeking financiers repeatedly took the blame. It is now time to revise that narrative. Financial returns and social welfare are no longer mutually exclusive. If the impact investing experiment is successful, the new storyline will be that within market capitalism, we found a way to transform invested capital into solutions to the world’s greatest challenges.

Notes & References

“Development: Aid to developing countries falls because of global recession”, Organisation for Economic Co-operation and Development, April 4, 2012.

“Report on Sequestration”, House Appropriations Committee Democrats, February 13, 2013.

Stephanie Strom, “Charitable Giving Rose Last Year for First Time Since 2007”, New York Times, June 19, 2011.

“Investing for Social and Environmental Impact: A Design for Catalyzing an Emerging Industry,” The Monitor Institute, January 2009.

Jonathan Greenblatt, “Opening the Door for Program Related Investments”, Office of Social Innovation and Civic Participation, The White House, May 4, 2012.

Allison is a first-year M.A. student in the International Development program concentrating in finance and development. She is a Thomas R. Pickering Graduate Foreign Affairs Fellow and an editor of SAIS Perspectives, the annual publication of the SAIS International Development program. Prior to SAIS she served as the Special Assistant to the President and CEO of the Overseas Private Investment Corporation (OPIC). She also worked on the Obama for America campaign in 2008. She holds a bachelor’s degree in Political Science from the University of Vermont and grew up in New England.